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How Do Interest Rates Affect The Foreign Exchange Rate?

Mon 23rd July 2012

by Peter Lavelle

The basic answer to this question is this: if interest rates go up, the foreign exchange rate tends to improve. Conversely, if interest rates go down, that causes a currency to weaken. But let’s look at it in a bit more detail.

If say the Bank of England were to raise interest rates from 0.5% to 1.0% next month (which there’s no chance of it doing) it would help the UK pound climb against other currencies, including the euro or US dollar.

This is because, when interest rates in a country are high, the yields (or returns) on offer for investing in that country also tend to be high. That encourages people to invest there, which requires them to buy that country’s currency. That in turn raises the value of the currency, because it’s more in demand (the same way in which, if more people start buying milk, the price of milk will go up, because there’s more demand for it.)

In short, high interest rates in the UK mean more reason to buy the pound, increasing its value.

Of course, as I mention, this also works the other way. As a central bank cuts interest rates, the returns available for investments in that country tend to decline, reducing demand for a currency and hence its value. In 2008, this was in part responsible for the sudden drop in the value of the pound, as the Bank of England cut interest rates to a 0.5% record low, in order to make borrowing cheaper and so aid the economic recovery.

More than most factors that affect the exchange rate, it’s pretty hard to overstate the influence of interest rates. As well as playing a big part in the 25% decline of the pound as I mention, high interest rates in Australia have also helped the Australian dollar enjoy massive gains lately.

In Australia, the Reserve Bank of Australia has its benchmark interest rate at 3.5% at the moment, higher than (I think) any other developed country in the world right now. That makes it hugely attractive, which helps explain the strength of the dollar.

But in spite of this, we shouldn’t think that interest rates are the be-all-and-end-all where exchange rates are concerned. Until recently for instance, the European Central Bank held interest rates at 1.00%: higher than both the US and UK.

But that didn’t help the euro retain its value, which, in the face of the continent’s debilitating debt crisis, has lost against both the pound and US dollar in 2012. In this way, though interest rates are influential, they’re not necessarily definitive.

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I do hope this post has been helpful.

If you have any questions about the exchange rate, don’t hesitate to call us on +44 (0) 1494 671800 or email enquiries@purefx.co.uk. You can also visit us at foreign exchange specialist Pure FX. We’d be delighted to help.